Investor Alert: Target Date Funds Not Always A Smooth Ride

Jan 17

If you contribute to a retirement plan at work, you probably have the option to invest in a target date mutual fund (TDF), an investment that is promoted as one-stop shopping for retirement savers.

A target date fund is designed, basically, to save investors from themselves. Too few investors do the work of constructing a sensible retirement portfolio – picking different mutual funds, often from a bewildering array of options, and then rebalancing their portfolio as needed.

An investor instead can choose a TDF pegged to their expected year of retirement or the year his or her child goes to college. A 2040 target date retirement fund, for example, starts with a portfolio mostly in stocks, then shifts over time to fixed income so the fund, in theory, becomes less risky as an investor approaches retirement.

The gradual reallocation of assets is called the fund's "glidepath"– a reassuring word that implies a smooth landing.

The Financial Security Project (FSP) at Boston College, in fact, says that "unless you have a good reason to do something else, a target date fund is a reasonable place to put all your retirement savings."

Are target date funds really that good? Do investors truly understand the risks of target date funds? In this Investor Alert, we look at the increasing popularity of target date funds, the conflicting research about their effectiveness, and investors' misconceptions.

The Popular Kid in School

There's no debate about the popularity of the target strategy. In 2011, 72% of 401(k) plans offered target date funds compared with 57% in 2006, according to the Employee Benefit Research Institute. Approximately 39% of 401(k) participants were invested in target date funds in 2011. The funds are especially popular with younger workers and new hires, who tend to invest in target date or other balanced funds with a mix of stocks and bonds.

The growth of target date funds is also due to a 2006 U.S. Department of Labor ruling that permitted employers to use the funds as a default option for retirement plans. In a default option, if an employee doesn't sign up for a 401(k) a company will typically take 1% or 2% of the worker's pay and invest in a target date retirement fund.

In "Why Target Date Funds?" the Financial Security Project says very few people do what financial professionals recommend – and that is, to minimize risk, investors should shift from stocks to bonds as they age. Target date funds can do that job for investors.

Besides reallocation, the Financial Security Project asserts that target date funds generally hold up better in severe market downturns and that their structure results in a quicker recovery. One reason is that after a market downturn target date funds must rebalance their portfolios to maintain their allocation.

After a market crash like that of 2008, a target date fund with half its assets in stocks and half in bonds would have seen its stock allocation plummet in value. To get back to the 50-50 mix, the fund would buy stocks - at lower prices - and sell bonds, which rose in value. It's an enforced version of buy low, sell high.

How Smooth a Landing?

But along comes Robert Arnott, the CEO of Research Affiliates, who has offered his typically contrarian view in a report called "The Glidepath Illusion."Arnott argues that historical market returns show that an investor would earn more for retirement if she followed the exact opposite of a target date strategy.

"Shockingly, the basic premise upon which these billions are invested is flawed,"Arnott writes.

Drawing on 141 years of stock and bond market returns from 1871 to 2011, Arnott analyzed the potential outcomes for individuals who save for retirement from age 22 to 63. One hypothetical employee saved $1,000 a year, adjusted for inflation, for a total of $41,000. If she invested in a typical glidepath portfolio, starting with 80% in stocks and 20% in bonds, she would have reached retirement with an average portfolio value of $124,460.

Arnott's simulations show a wide range of outcomes, however. The investor could have ended up with as little as $49,940 or as much as $211,330.

Arnott found that an investor who flipped the glidepath on its head – starting with 20% stocks and 80% bonds and shifting to a mostly stock portfolio – would have earned more than the standard target date strategy. At age 63, the investor's average portfolio would be worth $152,060. The minimum portfolio amount was $53,040 and the maximum was at $286,920. According to Arnott, the reason this "inverse strategy"prevails is that the investor is "ramping up her risk late in life when the portfolio is already large."

Even an investor who maintained a 50-50 allocation, Arnott found, would earn more for retirement than a target date investor. (While maintaining a portfolio that tracks an "inverse glidepath"strategy might be tricky for an investor, it would be easy to keep a portfolio split equally between the broad stock and bond markets.)

Not All Funds Are Created Equal

Target date funds are almost certainly here to stay unless employers have a change of heart or TDFs stop being a default option for workplace retirement plans. So investors should know that even though these funds share the target date label, they can be very different animals.

Even investors who hold target date funds are unclear on the concepts, such as the crucial fact that TDFs do not provide guaranteed income in retirement. According to a 2012 survey conducted for the Securities and Exchange Commission, 48% of TDF owners didn't know that. For those who don't own TDFs, the correct response rate was 26%.

Funds with the same target date can have very different allocations, so investors should determine whether a fund is too conservative or too aggressive for their goals. Target date funds are supposed to spare investors that sort of analysis. They don't.

The differences in allocation mean target date funds of the same vintage perform very differently. Some target date funds suffered unexpectedly massive losses in the market meltdown of 2008, while others lost value in line with their allocation.

Some TDFs cost more than others, resulting in a big difference in savings. Let's say you start with $1,000 in retirement savings and invest an additional $500 a month for 20 years. Your annualized rate of return is 6%.

A TDF that charges 0.2% of your assets produces a total of $225,843 after 20 years. A TDF that charges 1% gives you $206,382, a difference of $19,461.

For more about the impact of costs on investments, the basics of mutual funds (including TDFs), the tradeoff between risk and return – and a whole lot more – we suggest two resources from the Texas State Securities Board:

The Texas Investor Guide: Strategies for Investing Wisely and Avoiding Financial Fraud

Everyone's Investment Guide, our six-part, interactive educational presentation. It doesn't make sense to jump into an investment without a basic understanding of the investment world, including all types of mutual funds.

And regardless of which strategy an investor chooses, we can all agree on one point Arnott raises: "No strategy can make up for inadequate savings or premature retirement."